How to Play a Slowing China

It has been a tough few weeks for China investors. After looking like the nation's slumping stock market had turned a corner, a wave of bad news sent it tumbling again.

That could present opportunities for patient investors, experts say.

ENLARGE

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After falling 18% in 2011, the MSCI China index rocketed up nearly 18% in January and February, its best start of the year since 1996.

But the rally has stalled, with the MSCI falling 2.7% in March. The reason: Concerns about Chinese economic growth. On March 7, Chinese policy makers announced they were targeting economic growth of 7.5%, slower than in past years, and two days later reported a trade deficit of $31.5 billion in February, the largest since at least 2000.

Some strategists, however, say the spate of bad news might actually be a positive sign for China's economy—and its equity markets.

The growth rate, while lower than the double-digit clip many investors had come to expect, is a sign that China intends to make the transition from an economy dominated by exports and state-targeted investments to one that is fueled by consumers, says Anna Stupnytska, a London-based macroeconomist at Goldman Sachs Asset Management. While that might mean slower growth, it also should be more stable in the long term.

"This transition is absolutely necessary to make the economy sustainable," she says. "The rise of the Chinese consumer will be the most important trend in the coming decade."

That isn't to say the change will be easy on investors. The Chinese stock market typically moves in tandem with industrial-production growth, says Tony Welch, a global analyst at Ned Davis Research.

Since 1994, during periods when the amount of goods produced by China has trended higher, the market gained an annualized 6.1%; it lost 10% when industrial-production growth was falling. Right now, the direction of industrial production is unclear, but with the transition under way, it could take a hit.

"Growth could be decelerating for some time," Mr. Welch says. "If you saw extreme weakness in China, it could break the whole China trade."

Still, many strategists expect the People's Bank of China to stimulate the economy, now that inflation has dropped to a manageable 3.2%. When the central bank began easing monetary policy in 2008, stocks rallied 30%.

"They have the tools they need to keep this from becoming a much worse slowdown," Aaron Gurwitz, chief investment officer at Barclays Wealth, says of China's central bankers. "If they're able to manage the cycle and manage away from an export-oriented growth strategy, people will make a lot of money on investments in China."

So how should investors take advantage? One popular way to play China has been to look for U.S.-based multinational companies with exposure there, including McDonald's,MCD0.70%NikeNKE0.18% and Yum! Brands.

Recent concerns about Chinese growth also have made some of these companies cheaper than they have been recently, says Mark Finn, manager of the T. Rowe Price Value fund. He owns Emerson Electric,EMR-0.44% which has a price/earnings ratio—a valuation measure computed by dividing share price by earnings per share—of 14 based on profit forecasts for the next 12 months, below its 15-year average multiple of 18. He says he has been adding to his position recently.

Jeff Shen, a managing director at asset manager BlackRock, says investors should consider buying "the real thing"—Chinese equities. The P/E ratio of the FactSet Aggregate China Index, a gauge of Chinese stocks, is about 9.9, below its 15-year average of 12, according to FactSet Research Systems data.

"Chinese companies aren't that expensive, and that hasn't always been the case," Mr. Shen says. "Right now, they're more interesting than China proxies."

There are two kinds of China stocks—A shares, consisting of companies traded on mainland China, and H shares, or Chinese companies traded in Hong Kong.

A shares have lost 3.3% over the past five months, and are near their lowest valuations in five years, says Jonathan Garner, chief Asia strategist at Morgan StanleyMS-1.17% in Hong Kong.

H shares, on the other hand, have gained nearly 18% over that period. The wide gap is a sign that the A shares soon might find a trough, Mr. Garner says.

"There's been a huge outperformance in China shares listed in Hong Kong," he says. "We're interested in switching to the A market."

One problem with A shares is that they are generally restricted to Chinese investors. The Market Vectors ChinaPEK-0.83% ETF, however, gains access to the market through "swaps"—a type of financial contract that provides similar returns.

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